Trickle Up or Trickle Down?

Now that I got the details of the GSE takeovers out of the way with my last post, I wanted to write a more controversial opinion piece about this socialization of the mortgage market. As with many opinion pieces the topic is overly simplified in order to get the opinion across, but that's where all the fun is!

First let me note that although it is socialization now, the plan is to wind down the GSEs to approximately one quarter of their current size so ultimately this is a mortgage market privatization plan as much as it is a socialization plan. What has caused all of this turmoil? How did we get to this point? Here is one perspective for your consideration.

First, lets put a few factors into play. The divide between rich and poor has gotten very wide – the GINI coefficient has risen from under 40 in 1967 to 47 in 2006 (from Wikipedia.org). Second, we have seen falling or flat real wages as globalization has put pressure on labor’s ability to negotiate increases at the same time labor has become more productive by leaps and bounds. Third, corporate profits have been excellent over the past several years prior to the “credit crunch”. Finally, we have witnessed a huge increase in the level of debt owed by the average American household. Are all of these things related? I think they are, and my conclusion may not sit well with free marketeers.

At the heart of a capitalist system is the drive for profits. This drive, in an environment of free market competition, should result in innovation and, in turn, a rising standard of living. I agree with this concept and believe that there should be competition in markets. But does this system always work without unacceptable excesses? Of course not, and the current fallout is just one example. I believe that the imbalance of power between capital and labor has had a lot to do with our current situation, and if that sounds Marxist so be it.

Capital seeks profit. This is what drives a capitalist system. It gets profits by taking some of the value created by labor and keeping it for the owners of capital rather than sharing it with the producers – labor. Whether you believe this is good or bad is irrelevant for my purposes, so I will dispense with value judgment here. In order to maximize profits owners of capital seek to compensate labor at lower levels, and modern globalization together with governmental trade policies have enabled owners to take the upper hand in labor/wage negotiations. This is clearly evident in the fall of unionization and falling real wages, and is currently playing out at Boeing as labor seeks to limit management’s ability to outsource production. By successfully seeking lower labor costs owners created increased profits (lower labor costs net of increased transportation expenses). The higher levels of profit meant more new capital seeking profit. That means more investment in productive capacity. If the system gets out of balance, there is too much capital seeking profit and we get over-production. The problem is, who will purchase the surplus production, especially when real wages are falling? In theory this would result in declining prices and capital would be allocated away from production because profits would fall. So what got in the way of this process? Where is the invisible hand?

Enter leverage, the elixir. All of the excess capital was turned into even more excess capital through leverage in the financial industry. This leverage is evident in all of our financial institutions, from the failure of Bear Stearns to the liquidity crisis to the socialization of the GSEs. Leverage was enabled by our government through regulatory steps that opened the door for massive levels of debt relative to the existing pool of capital. This partnership between Wall Street and Congress is, I believe, bi-partisan and well entrenched. The result – consumers had the capacity to borrow and purchase even though they did not have the income to support the ongoing cost of ownership. Therein lies the imbalance between capital and labor that has resulted in our current situation. Too much capital allocated to production and lending for consumption, not enough wages to support ownership. The signs are there – rising inequality between rich and poor, outstanding corporate profits (until recently), consumption exceeding production, and stagnant or falling real wages. Now, as losses mount in the capital and money markets from all of the foolish extensions of credit (capital seeking profit), the process goes into reverse. Credit is difficult to come by and only allocated to the most worthy of borrowers. Consumers can no longer consume above their incomes and the price adjustment process that should have occurred a long time ago arrives with ferocity. Welcome to the credit crunch! What was the cause? Unrestrained and under-regulated capital.

As we de-leverage business profits will suffer from falling demand, asset prices will fall, and unemployment will rise. For the less well off there is the struggle to maintain the household, obtain food, and keep up with payments. For those with capital there is the struggle to preserve and grow it in an environment where prices are unstable. The current struggle is also playing out in the context of the political contest for President. Whether both parties are actually shills for the wealthy interests is a matter for debate and many believe this to be the case. Taking the candidates at face value, however, the Democratic party is calling for a redistribution from wealth to wage, while the Republican party is calling for a reduction of social benefits for wage earners to pay for ongoing tax cuts that benefit high income earners and owners of capital. Trickle up or trickle down. That is the question.

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